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Part III: Credit Default Swaps Create Less-Than-Zero Value
(Zeus Y. Ph.D., October 13, 2008)
First, let us establish that “credit default swaps” (CDS’s) are an unregulated form of credit default insurance that had to be titled “swap” (a trading term) to avoid being regulated like actual insurance. Because it was unregulated, there were no capital reserve requirements, that is, no money was required to be held to pay out if someone actually did default. So CDS’s could easily (and were easily) simply counterfeit documents guarding against risk without any collateral. So at best they are worthless, and with a 70 trillion dollar market in counterfeit goods, it is safe to say we are in trouble without some way to rescale assets distorted by the introduction of counterfeit financial instruments like CDS’s that have grown to be larger than the global GDP. My own feeling is that massive debt forgiveness will have to be part of the fix.
Now, how can a supposed “asset” like credit default swaps have a “less-than-zero” (negative) value. First, credit default swaps were insuring debt. Debt is not an asset as I explained in previous essays, but a liability. Mistake number one was to confuse asset and liability. These debts were treated as assets because in theory they produced interest income and transaction or service fee income at pretty high initial rates of return (based on the inflated value growth of housing, for instance). Unfortunately, the models they were based upon had no contact with reality. They assumed unlimited growth and ability to pay. When matched against the reality of people paying ten times their salary for mortgages that actually added more money owed to their principal (i.e. with negative amortization), required no money down, and set up “balloon payments,” large step-ups in payments after a few years) there is no possible way they could NOT default in a predictable span of time.
Even someone without math training could see that the fundamentals were way off and that the assumptions had to be false, BUT those profiting did not care. “Mark to model” (or “mark to fantasy” as some have called it) presided over “mark to market” or “mark to reality”, allowing maximum short-term return for a system based on a conspiracy of greed that created phony prosperity down the line: earning big money for crooked rating agencies (Moody’s and Standard & Poor’s garnered huge fees for rating junk as AAA), “socializing the liability and privatizing the gain” for big investment banks and hedge funds, and pulling in nice commissions for loose-lending mortgage brokers, etc. Housing prices were way off the historical mean, with payments three times what it would cost to rent the same house in California, for instance. Again it does not take a math genius or a clairvoyant to see that things are far out of whack and to be certain about a crash coming as the accelerated frenzy reached critical levels.
If you spend good money for an insurance policy against debt default (which is what a “swap” ostensibly was) as with any insurance policy (against your house catching on fire, for instance), and the policy pays you nothing when catastrophe does in fact happen, the value of that policy is zero. If you pay premiums, maintenance, or transaction fees to keep that worthless policy active, you have less-than-zero value: the money you spent into the policy could have been invested elsewhere or even held under a mattress and still retained some value. If you own a chunk of a CDS market as part of your portfolio, it is even worse: you have something that is worthless (has zero value), upon which you are paying premiums (less-than-zero value), and which is actively sabotaging by its very pernicious presence in the market the real value of other parts of your portfolio (worse than less-than-zero value). As anyone who has an index fund can attest, the Dow Jones lost a third of its value in just a half-year or so in large part because of the overall uncertainty about value created by CDS’s.
Put it this way, store money in an insured CD and you get to keep the value of your principal and a return that usually meets or exceeds inflation. So you have the value of your principal retained and a return (positive value + return). Keep the money under a mattress and you retain the principal, somewhat devalued by inflation, but still largely retaining its value (positive value). If you keep the money under you mattress and your bed burns down, you are left with zero value. If you pay someone to insure your money, your bed burns down, and they don’t pay out, you have less-than-zero value. With CDS’s, it is the equivalent of paying an arsonist to set fire to your house, burning it, your bed, and your money, to the ground. This is what I mean by “worse than less-than-zero value.”
I am almost certain that part of the liquidity problem right now is that counterfeit assets (CDS’s, etc.) were traded for hard assets (cash, etc.) and promptly stashed in non-transparent accounts to “lock in” gains and hide the assets. Part of the clean-up of this global, criminal enterprise will have to involve auditing Swiss and other “off shore” bank accounts (where I would not be surprised to see trillions of dollars of cash have been stashed), private equity funds, hedge funds, and the like. The Swiss banks have already shown their untrustworthy moral standing in the matter by hiding tens of billions of dollars of cash and valuables for very long periods of time derived from Nazi theft of Jewish assets.
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